M A R G I N A L

C O S T I N G
D R . A J AY K U M A R
YA D AV
INTRODUCTION
• Marginal costing distinguishes between fixed costs and variable costs as convention ally
classified.
• What is Marginal Cost?

• Marginal cost is defined as cost of producing one additional unit. Thus, marginal cost is the
amount by which total cost changes when there is a change in output by one unit.
• Marginal Cost means Variable Cost. Marginal cost per unit remains unchanged irrespective of the
level of activity or output.
• Marginal cost of a product “is its variable cost”. This is normally taken to be; direct labour, direct
material, direct expenses and the variable part of overheads.
CONTD…’
• Marginal cost is equal to the increase in total variable cost because within the existing production

capacity, an increase in variable one unit of production will cause an increase in variable costs
only. The fixed costs remain same. In marginal costing, only variable costs are considered in
calculating the cost of product, while fixed costs are treated as period cost which will be charged
against the revenue of the period. The revenue generated from the excess of sales over variable
costs is called contribution

• Mathematically, Total sales – Variable costs = Contribution

• Sales = Variable cost + Contribution

• Sales – Variable cost = Fixed cost ± profit/loss

• Contribution – Fixed costs = Profit

NUMERICAL
Given
• Production = 100,000 units

• Sales 90,000 units @ Rs. 3 per unit

• Variable manufacturing costs = Rs. 2 per unit

• Fixed overheads= Rs. 50,000

• Selling and distribution costs = Rs. 10,000 of which Rs. 4000 is variable

Prepare the income statement under absorption costing and marginal costing.
CONTD…,
• Under Marginal Costing technique, only variable costs are charged to cost units, the fixed costs
attributable to a relevant period are written off in Costing Profit & Loss Account against the
contribution for that period. Under Marginal Costing Technique, fixed costs are treated as period
costs.
• Marginal Costing is also known as:

– Contributory Costing
– Variable Costing
– Comparative Costing
A D VA N T A G E S O F M A R G I N A L C O S T I N G
• Simplified Pricing Policy Since marginal (variable) cost per unit remains constant from period to
period over a short span of time, firm’s decisions on pricing policy can be taken.
• Proper recovery of overheads Overheads are recovered in costing on the basis of pre-determined
rates. Under marginal costing technique, fixed overheads are excluded and hence there will be no
problem of under or over recovery of overheads.
• Shows Realistic Profit Under Marginal costing technique, the stock of finished goods and work-
in-progress are carried on variable cost basis and the fixed expenses are written off to profit and
loss account. This shows the true profit of the period.
A D VA N T A G E S
• How much to produce Marginal costing helps in the preparation of break-even analysis which
shows the effect of increasing or decreasing production activity on the profitability of the
company.
• Helps in decision making Marginal costing helps the management in taking a number of business
decisions like make or buy, discontinuance of a particular product, replacement of machines etc.
D I S A D VA N T A G E S
• Sales staff may make mistake of marginal cost for total cost and sell at a price which will result
in loss or profits. Hence, sales staff should be cautioned while giving marginal cost.
• Overheads of fixed nature cannot be altogether excluded particularly in large contracts, while
valuing the work-in-progress.
• Some of the assumptions regarding the behaviour of various costs are not necessarily true in
realistic situation. For example: the assumption that fixed cost will remain static throughout is
not correct.
• Marginal cost ignores time factor and investment. The marginal cost of two jobs may be the same
but the time taken for their completion and the cost of machines used may differ. The true cost of
a job which takes longer time and uses costlier machine would be higher. This fact is not
disclosed by marginal costing.
C O S T- V O L U M E - P R O F I T A N A LY S I S
AND ITS OBJECTIVES

• It is a technique that may used by the management to evaluate how costs and

profits are affected by changes in the volume of business activities.

• Cost Volume Profit analysis is the analysis of three variables i.e. cost, volume

and profit. Such an analysis explores the relationship between costs, revenue,
activity levels and the resulting profit. It aims at measuring variation in cost and
volume.
• CVP Analysis is popularly known as Break – even Analysis, although there

exists a narrow difference between these two terms. CVP Analysis refers to the
study of the effect on profit due to changes in cost and volume of output,
whereas BE Analysis refers to the study of determination of that level of activity
where total sales is equal to the total cost and also the study of determination of
profit at any level of activity. However, the technique of BE Analysis is so
popular for studying CVP Analysis that these two terms are generally used
synonymously
I M P O RTA N C E
• The behaviour of cost in relation to volume.

• Volume of production or sales, where the business will break even.

• Sensitivity of profits due to variation in output.

• Amount of profit for a projected sales volume.

• Quantity of production and sales for a targeted profit level.

I M P O RTA N C E
• An understanding of CVP analysis is extremely useful to management in budgeting and profit
planning. It elucidates the impact of the following on the net profit:
• Changes in selling prices

• Changes in volume of sales

• Changes in variable cost

• Changes in fixed cost

ASSUMPTIONS OF COST VOLUME
P R O F I T ( B R E A K E V E N ) A N A LY S I S
• All costs are easily classified into fixed costs and variable costs.

• Both revenue and cost functions are linear over the range of activity under consideration.

• Prices of output and input remains unchanged.

• Productivity of the factors of production will remain the same.

• The state of technology and the process of production will not change.

• There will be no significant change in the levels of inventory.

• The company manufactures a single product.

• In case of a multi-product company, the sales mix will remain unchanged.

 FORMULA

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P R O F I T – V O L U M E R AT I O
• Profit volume ratio or contribution to sales ratio is a relationship between contribution and sales.
It is the ratio between contribution per product to turnover of the product. It is also termed as
contribution to sales ratio.
• PV Ratio is considered to be the basic indicator of the profitability of the business.

• The higher the PV Ratio, the better it is for a business. In the case of a firm enjoying steady
business conditions over a period of years, the PV Ratio will also remain stable and steady.
• If PV Ratio is improved, it will result in better profits.
I M P R O V E M E N T O F P V R AT I O

• By reducing the variable cost

• By increasing the selling price

• By increasing the share of products with higher PV Ratio in the overall sales ratio
P R O F I T V O L U M E R AT I O
P / V R AT I O
• Profit volume analysis is used to determine break even for a product, a group of products and to
know how the profit changes if changes are made in price, volume, costs or any combination of
these. But P/V graph does not show how cost varies with the change in the level of production.
• The profit volume ratio and contribution has a direct relationship. The profit volume ratio can be
improved by improving the contribution and contribution can be improved by : i) increasing the
selling price ii) decreasing the marginal or variable costs. iii) putting more emphasis on those
products which have higher profit volume ratio.
MARGIN OF SAFETY

• Margin of Safety (MS) is the level of sales made above the break – even point. In

other words, Margin of Safety is the excess of actual sales over BEP sales.
Generally, at any point of sales, contribution from sales is available towards
fixed cost and profit. But as the total fixed cost has already been recovered at
break – even point, contribution from sales at margin of safety is available
towards profit only, i.e. at MS, C = P.
NUMERICAL
X Ltd. Made sales during a certain period for Rs. 1,00,000. The net profit for the same period was
Rs. 10,000 and the fixed overheads were Rs. 15,000.

Find out:

(i) P/V Ratio.

(ii) Required sales to earn a profit of Rs. 15,000.

(iii) Net Profit from sales of Rs. 1,50,000.

(iv) Break – even point sales.

NUMERICAL
DB Ltd furnished the following information:
• (a) P/V Ratio.

• (b)Break-even point.

• (c) Total variable cost for 2004-2005 & 2005-2006.

• (d)Sales required to earn a profit of ₹60,000.

• (e) Profit/Loss when sales are ₹1,00,000.

• (f) Margin of Safety when Profit is ₹80,000.

• (g)During 2006-2007, due to increase in cost, variable cost is expected to rise to ₹7/unit and
fixed cost to ₹55,000. If selling price can not be increased, what will be the amount of sales to
maintain the profit of 2005-2006?
NUMERICAL
• For a manufacturing concern, when volume of production is 3,000 units, average cost is ₹4 per unit and
when volume of production is 4,000 units, average cost is ₹ 3.50 per unit. If the break-even point is reached
at 5,000 units of production and sale, find out the P/V Ratio.

• Rainbow Ltd. Sold goods for ₹ 30,00,000 in a year. In that year, the variable cost is 60% of sales and profit
is ₹ 8,00,000.

Find out: (i) P/V Ratio, (ii) Fixed Cost, (iii) Break-even sales, (iv) Break-even sales if selling price
was reduced by 10% and fixed costs were increased by ₹ 1,00,000.
USES OF MARGINAL COSTING FOR
DECISION MAKING
• Accepting an Additional Order: In case of spare capacity, a firm can increase its total profits by
accepting an special order above the marginal cost and at a price lower than its regular selling price.
The additional contribution earned from the special order will be the additional profit to the firm.
When additional order is accepted at a price below prevailing price to utilise idle capacity, it should
be carefully seen that it will not affect the normal market and goodwill of the company.

• Make or Buy Decision: A particular component used in the main product may be purchased or
may be manufactured in its own factory by utilising the idle capacity of the existing facilities. In
such make or buy decision, the marginal cost of manufacturing in the unit is compared with the
purchase price from the market. If marginal cost is less than the purchase price, then the component
should be manufactured in its own unit, otherwise it should be purchased from the market.
PROFIT PLANNING
• Marginal costing is very helpful in determining the level of activity to achieve
the planned profits. The separation of costs in to fixed and variable aid
management further in planning and evaluating the profit resulting from a
change in volume, a change in selling price, a change in fixed costs and variable
costs.
SALES MIX DECISION
• In marginal costing, profit is calculated by subtracting fixed cost from
contribution. It means management should try to maximise the
contribution. When a business firm produces variety of product lines,
then problem of best sales mix arises. The best sales mix is that which
yields the maximum contribution. The products which gives the
maximum contribution are to be retained and their production should
be increased keeping in view the demand. The products, which yield
less contribution, should be reduced or closed down depending upon
the situation.
NUMERICAL
ADDING OR DROPPING A PRODUCT
• An organisation may have a number of product lines or departments. Certain
product lines or departments may turn out to be unprofitable with the passage of
time or due to technological developments. Production of such products or
departments can be discontinued. The marginal costing approach assist in these
situations to take a decision. It helps in the introduction of a new product line and
work as a good guide for deciding the optimum mix keeping in mind the available
resources and demand of the product. The contribution of different products or
departments is to be compared and the product or department whose P/V ratio is the
lowest is to be dropped out.
NUMERICAL
SUSPENSION OF ACTIVITY
• During trade recession and cut throat competition the demand of the product is not
adequate to cover the fixed costs, management may consider to suspend the operations for
the time being. If certain portion of fixed expenses is escapable e.g. salary of temporary
staff then size of contribution should exceed the escapable fixed costs. In some units when
production is restarted after suspension, some additional or special costs are incurred like
overhauling of the plant and machinery. These costs are called additional costs of shut
down. These costs are deducted from the escapable fixed costs and amount of contribution
is compared with the net escapable fixed costs. If the contribution is greater than the net
escapable fixed cost, the production should be continued and vice versa.
NUMERICAL
L I M I T I N G FA C TO R / P R O D U C T M I X D E C I S I O N
• The marginal costing technique provides that the product with highest contribution per
unit is preferred. This inference holds true so long as it is possible to sell as much as it
can produce. But sometimes an organisation can sell all it produces but production is
limited due to scarcity of raw material, labour, electricity, plant capacity or capital.
• These are called key factors or limiting factors. A key factor or limiting factor puts a
limit on production and profit of the firm. In such situation, management has to take a
decision whose production is to be increased, decreased or stopped. In such cases,
selection of the product is done on the basis of contribution per unit of scarce factor of
production. The key factor or scarce factor should be utilized in such a manner that
contribution per unit of scarce resource is the maximum.
PRODUCT MIX DECISION